The Long and Short of Leveraged ETFs: The Financial Crisis and Performance Attribution

Abstract

Leveraged ETFs have received much press coverage of late due to issues with their performance. Managers and the media have focused investors' attention on the impact of compounding, when the funds are held for more than one day. In this paper, I lay out a framework for assessing the performance of leveraged ETFs. In particular, I propose a simple way to disentangle the effect of compounding and that of i) the management of the fund and ii) the trading premiums/discounts, all of which affect investors' bottom line. The former (i) is influenced by the effectiveness and the costs of the fund's (synthetic) replication strategy and the use of leverage. The latter (ii) reflects liquidity and the efficiency of the market. I find that tracking errors were not caused by the effects of compounding alone. Depending on the fund, the impact of management factors can outweigh the impact of compounding, and substantial premiums/discounts caused by reduced liquidity during the financial crisis further distorted performance.

Keywords: Leveraged ETF, inverse ETF, Exchange Traded Funds, Financial Crisis, Portfolio Performance